June Rates Update

Monthly Commentary

June 30, 2016

While the early days of June belonged to the Fed and their latest retreat towards a
dovish policy stance, it was the stunning result of the June 23 British referendum
vote and subsequent market reaction that will be forever engrained in the minds of
market participants. Indeed, the Leave vote carried the day by a tally of 52% to 48%
as populist sentiment proved too formidable an opponent for the status quo. Brexit
aside, June was a historical month by several other standards as sovereign yields
made all-time lows in Australia, Italy, and Spain saw the lowest yields in several
centuries and Dutch 10y debt yields dropped to the lowest levels seen in the last 500
years. In the context of a market that has seen over 600 interest rate cuts by central
banks globally since September of 2008, this may be less surprising than it seems at
first look.

When market participants refer to black swan or tail risk events, trading days like
those around the fall of Lehman and the announcement of QE1 are usually among
the first to come to mind. This month, the decision by the British constituency to
leave the European Union (EU) joined those momentous macroeconomic events as
10y U.S. Treasuries rallied 20bps the day following the vote as investors scrambled
for safety. The day’s price action was quite telling about the level of anxiety in
markets as the referendum’s result isn’t legally binding and the end game is far
from clear. Nonetheless, the newfound source of uncertainty exacerbated the bid
for higher quality assets and served to push the trade weighted U.S. dollar almost
3% higher on a month-over-month basis as investors fled risky assets. At the core
of the panic and subsequent price action was not just simple uncertainty, but also
the unsettling realization that Eurozone projects continued success isn’t a foregone
conclusion. Ever since European Central Bank (ECB) President Mario Draghi
promised to do “whatever it takes” to preserve the single currency union in 2011,
market participants had taken him at his word and believed the EU would endure.
Following the vote however, market price action suggested investors were markedly
less sure that the appeal of EU unity outweighed the remaining nation’s desire for
their own sovereignty.

The morning following the referendum result, British Prime Minister and Remain
supporter David Cameron made good on his promise to tender his resignation
in the event the electorate voted Leave. Prime Minster Cameron has agreed to
remain Prime Minister until the fall at which point new leadership will have to decide whether or not to invoke Article 50 of the Lisbon
Treaty. Under this article, the UK would have a two-year
period to re-negotiate its relationship with the EU and reach
a withdrawal agreement starting once the UK officially
notifies the EU of their decision to leave. The European
Council members, except for the UK, would then have to
unanimously vote on the guidelines under which the
European Commission would negotiate the terms of the
withdrawal agreement. A final agreement would then need to
be approved both by the UK and at least 20 out of 27 of the
remaining Member States. The final agreement would also
need to be approved by greater than 50% of the European
Parliament. During this period the UK would still be required
to abide by EU treaties, and the two-year period may only be
extended if approved by all remaining 27 member States.

If not for the British referendum, the June FOMC statement
would have been the biggest macro catalyst of the month
as Fed Chair Janet Yellen surprised the market with both a
dovish statement and meaningful downward revisions to Fed
Funds projections. For the statement, the Fed gave a nod to
May’s dismal NFP report saying, “the pace of improvement in
the labor market has slowed.” They also noted that household
spending has improved but business investment remained
soft. Notably, this statement was released without any
dissents suggesting that FOMC members are generally more
on board with a risk management approach then they may
have been in past meetings.

Though the statement showed a Fed that had turned
lukewarm on the idea of further policy tightening, it was the
Staff Economic Projections that showed a how large the shift
towards dovish policy was. Not only did the central tendency
fed funds rate projection for 2016 move from 90bps-140bps
to 60bps-90bps but the median projections for 2017, 2018
and the longer run fell significantly. Since the inception of the
release of the Staff Economic Projections in 2012, the long
run median forecast, referred to as the terminal rate, has
fallen 120bps to reach 3% most recently. This most recent
unexpected reduction in the Fed forecast of future hikes may
be a positive development for a Fed who has not quite been
able to get its finger on the pulse of the post 2008 global
economy. This low growth, low productivity backdrop that
the global economy has been mired in does not necessarily
beg for higher rates and this most recent revision to FOMC
suggests a potential paradigm shift toward this reality.

As a consequence of this month’s macro events, both
the Bank of Japan (BOJ) and the ECB are now faced with
additional headwinds to their objectives of returning inflation
towards their target. With the Fed taking further steps to back
away from their tightening bias and uncertainty stemming
from Brexit, both central banks are faced with the prospects
of having the impact of their own previous policy moves
undone. However, early reports suggest that neither central
bank plans to stand down in the face of uncertainty and are
both planning additional policy moves. For the ECB’s part,
initial reports suggest that a move away from the capital
key that governs QE bond purchase allocations could be in
the fold. By moving away from the capital key, the ECB will
be able to purchase more securities issued by economically
weaker periphery nations, which could be more beneficial than
purchasing additional, already quite negative German Bunds.
Conversely, the BOJ has been slightly less forthcoming with
their current thought process as it pertains to additional QE
leaving market participants to only guess at their intentions.
Given the recent strengthening in the Yen, it is clear that
the BOJ will have to take action sooner rather than later as
deflation looms and Prime Minster Shinzo Abe’s popularity
wanes. Both of these announcements were well received
by the market as Treasury yields pushed lower while global
equities pushed higher, suggesting that central banks still
retain non-trivial influence in the setting of asset prices for the
time being.

When the dust settled at the end of the month, 30y Treasury
yields had reached 2.30%, just shy of all-time yield lows.
However, despite a nearly 40bp rally in Treasuries, global
risk assets recovered reasonably well in the days following
the British referendum. It remains to be seen if this stability
can carry over into July as negotiations between the UK
and the EU have yet to begin in earnest while other EU
members contemplate their own future. Interestingly, in the
first political election in the EU following Brexit, the Podemos
party in Spain failed to garner enough votes to form a majority
government. This is quite notable because Podemos is
Spain’s resident Eurosceptic party and it might be expected
that their platform would have received further credibility
and potentially more votes after seeing a Leave vote succeed
in the UK. Whichever way the EU goes from here, closer or
further apart, the global macro picture has been significantly
altered as the knock on effect of this vote and subsequent
votes are sure have a significant impact on markets globally.

Source: Bloomberg

10y U.S. Treasury Daily Price Changes

Source: Bloomberg

GBP/USD Daily Price Changes

Source: Bloomberg

Economic Projections of Federal Reserve Board Members and Federal Reserve Bank Presidents
Under Their Individual Assessments of Projected Appropriate Monetary Policy, June 2016